The "Fractions Rule" in Partnership Agreements: Drafting - PowerPoint PPT Presentation

Presenting a live 90-minute webinar with interactive Q&A The "Fractions Rule" in Partnership Agreements: Drafting Section 514(c)(9)(E) Compliant Allocations Avoiding UBTI Triggers Through Savings Clauses and Other Structuring Tools WEDNESDAY, DECEMBER 7, 2016 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: Stephen Butler, Partner, Kirkland & Ellis , New York Jennifer A. O'Leary, Partner, Pepper Hamilton , Philadelphia The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 . NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no longer permitted.

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The Fractions Rule – Planning Opportunities and Pitfalls Under Proposed IRS Regulations Presented on: Presented by: Stephen Butler, Kirkland & Ellis LLP Jennifer O’Leary, Pepper Hamilton LLP * The authors wish to thank Demetre Klebaner, an associate at Kirkland & Ellis LLP, for his assistance in preparing this presentation.

Topics Covered I. Background The Fractions Rule – Basics II. III. Specific Exceptions to the Fractions Rule IV. Practical Administrative Issues V. Drafting Approaches VI. Questions? 5

I. Background 6

Background – UBTI  Unrelated Business Taxable Income (UBTI) -- generally means gross income derived from any unrelated trade or business regularly conducted by a tax-exempt organization, which will be taxable notwithstanding the organization’s general tax -exempt status. Code § 512.  E.g. University decides to compete with Apple and manufacture and sell iPhones – IRS does not want tax-exempt organization to unfairly compete by taking advantage of its tax-exempt status to engage in activities unrelated to its charitable purpose.  Exclusion for Passive Income : UBTI does not include various forms of income generally associated with passive investment activities (e.g. dividends, interest, capital gains, rents). Code § 512(b).  Debt-Financed Income : Otherwise tax-free passive investment income is treated as UBTI if debt-financed. Code § 514(b).  Generally, the ratio of the “average acquisition indebtedness,” as defined in § 514(c)(7), divided by the taxpayer’s average adjusted basis in the underlying property, as defined in Treas. Reg. § 1.514(a)-1(a)(2), determines the portion of gross income from debt-financed property that is required to be treated as UBTI.  Debt-financed property is broadly defined as any property held for the production of income for which there is acquisition indebtedness.  E.g. real estate purchased with a combination of cash and new mortgage debt 7

Background – Real Estate Exception to UBTI  Real Estate Exception : Exception to UBTI debt-financed property exclusion for real estate owned by “qualified organizations”. Code § 514(c)(9).  Allows tax exempt entity to make leveraged real estate investments without incurring debt- financed UBTI.  Requirements : To meet requirements of real estate exception, the investment must meet a number of criteria:  Price for asset must be fixed at the date of acquisition (i.e. no contingent payments/earn-outs);  The amount of debt on the property is not dependent on revenue, income or profits from the property (i.e. no participating debt);  The real property must not be leased back to the seller or a related party;  Except where property represents less than 25% of the floor space in a building, and lease is on commercially reasonable terms.  The real property is not leased to, acquired from or financed by certain related parties, where the qualified organization is an ERISA pension plan;  Except where property represents less than 25% of the floor space in a building, and lease is on commercially reasonable terms.  The seller does not provide acquisition financing, except on commercially reasonable terms, and  If the investment is owned by a partnership, the allocation rules described below must also be met. Code § 514(c)(9)(B) 8

Background – Qualified Organizations  Who is a “Qualified Organization”?  Educational institutions (e.g. University endowments or private high schools)  ERISA pension trusts  Certain group trusts formed to own real estate and owned entirely by ERISA plans, governmental entities, and other 501(c)(3) organizations  However, a nonqualified organization (e.g., hospital) holding an interest in a group trust is taxed on a pro rata share of the items of income, net of deductions, that would be treated as UBTI absent the Fractions Rule.  Certain church retirement plans  Not Covered by Fractions Rule (i.e. not “Qualified Organizations”):  Non-educational charities  Hospitals and healthcare charities  Religious charities other than 403(b)(9) church retirement plans  State and federal governmental entities (although these may separately be exempt from UBTI under Code § 115). 9

Background – Allocation Rules  Allocation Rules: To qualify for the Code § 514(c)(9) exception, a partnership holding real property must meet one of the following rules:  All the partnership’s partners must be “qualified organizations”  Unusual for a real estate joint venture  Would preclude a taxable developer or sponsor participating in JV as an equity member  Each allocation to partner that is a qualified organization is a “qualified allocation” under Code § 168(h)(6)  Generally, this requires that the qualified organization be allocated a fixed and unchanging share of each item of income, gain, loss, deduction, credit, and basis in the partnership;  Not practical for a real estate joint venture with a promoted partner, carried interest, or special allocations of certain items (i.e. most real estate joint ventures)  OR  The Fractions Rule is met (see below…). 10

II. The Fractions Rule -- Basics 11

Fractions Rule  Fractions Rule Requirements  A qualified organization must not be allocated net taxable income or gain for any taxable year in excess of its fractions rule percentage  AND  Each partnership allocation must have “substantial economic effect” pursuant to § 704(b)(2).  Fractions Rule percentage : A qualified organization’s percentage share of overall partnership loss for the partnership tax year in which that percentage is the smallest.  Purpose : The Fractions Rule prevents a fund, joint venture or other partnership from disproportionately allocating taxable income to tax-exempt investors (who are not taxed on it), while disproportionately allocating losses to taxable investors (who can potentially use those losses as a deduction against other income).  Overall partnership income is the net amount by which aggregate partnership income and gain exceeds the aggregate partnership loss and deduction for a taxable year (while overall partnership loss is the converse)  Overall partnership income and overall partnership loss include all items of partnership income, gain, loss and deduction that impact partners’ 704(b) capital accounts (i.e. including certain items of tax-exempt income and non-deductible losses). 12